Changes in Monetary Policy and the Variation in Interest Rate Changes across Credit Markets

Article excerpt

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The conduct of monetary policy is most often interpreted in terms of the federal funds target rate set by the Federal Open Market Committee (FOMC), at least until recently when this rate effectively reached its zero bound and additional actions were then implemented. The federal funds rate is the interest rate at which private depository institutions, typically banks, lend balances held with the Federal Reserve to other depository institutions overnight. By targeting a particular value for that rate, the Federal Reserve seeks to adjust the liquidity provided to the banking system through daily operations. Because the federal funds rate applies to overnight transactions between financial institutions, it represents a relatively risk-free rate. As such, it serves to anchor numerous other interest rates that reflect a wide array of credit transactions throughout the U.S. economy, such as deposits, home loans, and corporate loans.

Because the federal funds rate anchors interest rates in many different types of credit transactions, monetary policy actions that move the funds rate in a given direction are expected to move other interest rates in the same general direction. However, the extent to which changes in the federal funds rate affect conditions in different credit markets may vary significantly from market to market. For example, changes in the federal funds rate may be closely linked to changes in the three-month Treasury bill rate, but potentially less so to changes in home loan rates. In that sense, changes in monetary policy, as reflected by broad liquidity adjustments through the federal funds market, will be more effective in influencing credit conditions in some markets than others. Thus, this article attempts to assess empirically the extent to which interest rate changes in various credit markets reflect changes in monetary policy. It also explores whether these relationships have changed over time.

As a first step, we construct a panel of 86 time series spanning a diverse set of monthly interest rate changes, including Treasury bill rates, corporate interest rates, repurchase agreement rates, and mortgage rates, among others. The panel of interest rate changes covers the period July 1991-December 2009. The empirical framework then uses principal component analysis to characterize co-movement across these interest rate changes. The basic intuition underlying the exercise is as follows: If changes in monetary policy tend to move a broad array of interest rates in the same general direction, then changes in these interest rates will share some degree of co-movement.

Having characterized the common variation in interest rates using principal components, we ask two questions. First, looking across all interest rate changes, which series tend to be mostly driven by common changes in interest rates rather than idiosyncratic considerations? In particular, idiosyncratic changes in a given interest rate series are orthogonal to the principal components and, therefore, unlikely to reflect a common element such as a change in monetary policy. Therefore, one expects that monetary policy will have only a limited effect on interest rates in which changes are mostly idiosyncratic. Second, recognizing that the common variation across interest rate changes may reflect a broad set of aggregate factors, howclosely is the common change component of each interest rate series (which may play a more or less important role in the characterization of different interest rates) related to changes in monetary policy? Furthermore, has this relationship changed over time?

Our results indicate that most of the variation across our sample can be explained by a small number of common components. For most credit markets, including mortgage, repurchase agreement, Treasury, and London Interbank Offered Rate (LIBOR) rates, four components explain approximately 70 percent or more of the variation in interest rate changes. …